Guest Interview:

Forward Management

433 California Street
San Francisco,CA 94104

Interview Quarter: 4Q2009

Randall Coleman, CFA,

Portfolio Manager

Mr. Coleman is a Portfolio Manager for Forward Management, LLC. In his role, Mr. Coleman is a member of Forward’s Investment Committee and oversees Forward’s SmallMid Core strategy. Previously, he was a portfolio manager and analyst for Berkeley Capital Management. Prior to Berkeley, Mr. Coleman was a portfolio manager at London Pacific Advisors from 1998 until 2001. He is a Chartered Financial Analyst and holds a BA from the University of California, Davis as well as an MBA from the American Graduate School of International Management (Thunderbird).

The Forward SmallMid Core (SMID) investment philosophy is based upon the belief that superior investment results can be achieved by constructing a style and sector neutral portfolio of profitable small- and mid- sized stocks. The investment team strives to achieve superior returns by selecting companies with positive current earnings and reasonable valuations. Typically, investments include companies focused on one business which routinely pay cash dividends.

Tell us about the history behind Forward Management.

Founded in San Francisco in 1997, Forward Management, LLC is a privately held investment management firm providing investment services to a variety of institutional and high net worth clients. Forward has evolved through a series of entrepreneurial ventures with specialty investment teams. Beginning as the advisor to the Forward Funds, and now through its internal asset management teams, Forward continues to provide its clients with targeted investment strategies.

In August of 2008, Forward Management acquired the team and assets of the San Francisco Division of Berkeley Capital Management. The team from Berkeley Capital includes three investment professionals—David Ruff, Bruce Brewington, and me. At Forward, we manage four products with a similar approach—three dividend-based strategies (domestic, global, and international dividend portfolios) and the Forward SmallMid Core Portfolio that I’m the primary manager on. We average 20 years in the investment industry and we utilize a team approach with a lead manager on each product. We all sit at the same trading desk during the day, so we are constantly bouncing investment ideas off of each other and talking about the stocks in the various portfolios. There is a lot of give and take with the investment team and we feel that we have been very successful with this approach.

What are the core beliefs of Forward regarding the SmallMid Core strategy?

Forward Management believes the Forward SmallMid Core Portfolio is unique in its attention to risk control by investing in both growth and value companies. We purchase smaller cap companies and typically hold them until they reach mid cap. Additionally, for a small cap manager, we hold a relatively few number of positions and the portfolio has low turnover.

The portfolio is concentrated with a deep focus on companies with a definable competitive advantage. The long holding period allows the companies we hold to grow over time.

What is the process you use to find market opportunities?

We identify companies, primarily from the Russell 2500 index, with positive characteristics for profitability, growth and cash flow. We then eliminate companies with negative attributes, such as excessive valuation, deteriorating margins or questionable financial strength. We are seeking companies with profitability of at least 15% return on equity and premium return on capital, usually measured over a 3-year time period. The remaining companies are then tested for above-average earnings growth and earnings yield.

We favor companies with dominant niche position and we focus on the company’s fundamental position and industry characteristics. Our industry review considers the number of competitors, capacity utilization, and ease of entry and growth characteristics.

Our fundamental research emphasizes the company’s financial statements, which need to reflect clean accounting and have understandable disclosures. We look for experienced management who communicate a clear, well-defined strategy for growth, and we purchase candidates that typically have lower institutional ownership and relatively lower earnings volatility.

We have a very focused sell discipline and position weightings are trimmed when allocation limits are exceeded and sold when company’s operations have underperformed its industry, the company experiences a negative change in fundamentals, better alternatives exist or the price appreciation target has been achieved.

How was your investment process developed?

We took a look at what we thought were frequent mistakes made by small cap managers. Most notable here is a mandated removal from portfolios of companies meeting with success, namely, selling companies that cross some arbitrary market capitalization threshold. With our long-term outlook, we do not penalize investors by selling a company because it is doing what it ought to be doing: we’ll hold on to that company. For our quantitative screening, through our ongoing research, we have identified certain attributes associated with likely future underperformance. We have built these avoidance criteria into our screening model.

Does the portfolio ever hold cash and under what investment circumstances?

The portfolio is typically fully invested, although during periods of high volatility, cash can be as high as 15%.

Where does Forward’s research come from?

All members of the portfolio management team participate in research and we generate approximately 75% of our research internally, and source approximately 25% of our research from other providers.

What is the environment for SMID stocks in 2010?

There are three general trends in particular that we are looking for this year. First, we expect an increase in mergers and acquisitions activity. While it probably will not reach the levels M&A did in 2006 - when five of our portfolio holdings were taken out - the environment for M&A is quite good. Companies have lots of cash on their balance sheets and they are looking to grow via acquisitions. Second, we believe investor focus will return to higher quality companies. This definition can take several meanings, but for our purposes, it encompasses companies with real earnings and good balance sheets. This is the sweet spot of our SMID portfolio. Finally, we expect sector rotation to help us. Typically during recoveries, the leading sectors of the prior year do not repeat their outperformance the following year. In 2009, Consumer Discretionary, Technology and Energy led small cap performance. We do not believe that this will occur this year and we currently are overweight in the Industrial/Producer Durables sectors to take advantage of this potential rotation.

Where are you finding opportunities in the SMID area?

The incredible run we had in 2009 made it tough to get excited about adding companies. With the pullback we have seen in the last two weeks, it is a much better environment for culling through candidates. It is not that I absolutely will not buy a stock making a 52-week high, it is that I much prefer to find them well below their trading highs. Quite a few very attractive, very profitable companies are coming through our screens as we start 2010.

What is the definition of small and mid as far as your portfolio?

Our selection universe is roughly the Russell 2500, and its range is $100 million to around $8 billion. Our initial screen starts at $100 million and goes up to the $4 to $5 billion range. You will find larger companies in the portfolio because we like to hold onto our winners as they grow. We are not going to penalize investors by selling a successful company just because it has crossed an arbitrary market cap limit.

About how many holdings generally do you have in your portfolio?

The strategy is typically a 30 stock portfolio which is equal weighted, and there were 30 positions in the portfolio as of December 31, 2009. The portfolio holdings can range from 30-35 securities. Individual securities selected for inclusion in the Forward SmallMid Core Portfolio may be weighted at a maximum of 4 percent at time of purchase and more volatile securities may be purchased at 2% or less for inclusion within the portfolio. With market appreciation these positions can increase to a maximum limit of 7 percent. Typically a holding period for a security in the Forward SmallMid Core Portfolio is 3 to 5 years.

Tell us about the investment decision-making process, what are the investment criteria that you are looking for in the SMID stocks?

We utilize a two-step process, quantitative then qualitative. The quantitative step is the computer-driven screen where we narrow down the universe looking for companies that fit the financial characteristics we’re looking for. Here we screen for profitability using a 15% ROE hurdle, positive cash flow, superior earnings growth on the growth side or significantly higher earnings yield on the value side. We have built into our model some avoidance criteria as well. We stay away from the very far right end of the valuation tale, where companies trade at multiples of more than two times their growth rate and we avoid companies with highly leveraged balance sheets, with debt-to-capital over 50%. The second step we do is the qualitative screen. This is where we feel we add the most value and where we ultimately do what we get paid to do.

The underlying investment philosophy of the product mandates that we select only focused companies. By “focused,” we mean that they operate in only a single business segment. By far, the most frequent reason for exclusion under our qualitative criteria is the lack of business model focus. We look for niche dominance, some sort of sustainable competitive advantage, a strong portfolio of intellectual property, a history of innovation, those sorts of things. We also like to see managements’ interests and compensation aligned with shareholders’ interests.

Business “focus” is a critical criteria for several reasons—as portfolio managers, we want to be in control of our diversification—we don’t want conglomerates that behave as portfolios themselves. Particularly for smaller companies, management will have fewer diversions with a single business to concentrate on – there’s less to be distracted by. Additionally, and quite frankly, focused companies are easier to analyze. Their 10-K’s and 10-Q’s are shorter, where shorter is usually better.

What is the benchmark that you use to measure your performance and do you have overweights and underweights compared to the benchmark?

Forward’s SmallMid Core Portfolio is relatively sector neutral. Major sectors are typically 10 percentage points of the benchmark. Minor sectors are within 2x the weighting of the benchmark. We are typically void utilities and telecommunications due to their regulatory environment and limited growth prospects.

Has there been a shift in emphasis in your portfolio in the last 12 to 18 months?

With the domestic economy slowing, we have been more mindful of companies with foreign revenue. Even though the portfolio is primarily domestic, about half the holdings have more than a third of their top line coming from outside the U.S. Aside from that, we have made no changes to our underlying screening process.

What are some of the companies that you feel are representative of your investment approach?

That’s a very good question and it really speaks to the qualitative selection criteria that we use. A great example of a highly profitable, highly focused, niche dominant company is Ritchie Bros. Auctioneers (RBA). They are the world’s largest industrial auctioneer; that’s the only thing that they do and they excel at it. It’s a highly fragmented market and Ritchie Brothers is bigger than the next 40 industrial auctioneers combined. Essentially, it is a natural monopoly with a global footprint and we don’t think any company will ever be able to surpass it.

Another highly profitable, niche dominant company is McCormick (MKC), the spice company. McCormick has been in the portfolio since its inception. We’re talking about a holding period here approaching ten years, which to me is pretty amazing when you look at typical holding periods for stocks measured in months or weeks. Since we’ve owned McCormick, the position has returned more than 9.4% annualized, versus 3.2% for the consumer staples group over the same period.

I think a lot of our value-added comes from our very long-term investment horizon and companies like McCormick that we feel are dominant players in their respective spaces are for the types of companies we like to own.

What about the sell discipline? What triggers an exit from this portfolio?

Our trimming policy has been the most important mechanism we’ve used to reduce exposure to positions. By policy, we will trim positions that grow to over 7% of the portfolio. We have been in the fortunate position to implement this policy on several occasions, and trimming is more a risk management tool than anything else. An outright sell decision is driven more by a change in fundamentals or if something has happened to the company that alters our underlying investment thesis.

Often when people ask about sell disciplines, they are looking for a hard and fast price-based rule. We’ve found that, particularly in the more volatile small- and mid-cap space, you would do more harm than good with a price-based sell discipline because of the whipsaw effect: you would end up selling at the bottom, and that does not fit with our long-term investment horizon.

Here’s a good example, and while it is not one of my favorite stories, it is a very illuminating story. We bought ARM Holdings (ARMHY) at the end of the third quarter in 2002. Shortly thereafter, I walked into the office to news that the stock was down big with a more than 50% correction. What went wrong? The company had announced an earnings miss and a slowdown in orders. They were still going to make money, just at a slower pace. Nothing fundamentally had changed with the company.

I do not know of any price-based sell disciplines that would have allowed me to hold on to the position. But because nothing within the company’s control had changed, we held onto it and that turned out to be our best performing stock over the next 12 months, more than recovering beyond our buy point. The ugly secret is that with higher volatility stocks, a hard and fast sell discipline doesn’t work. Marketing departments don’t like to hear that, but we feel that as managers, as stewards of people’s capital, that our method works out better in the long run.

It can be a gut wrenching decision to make and it leaves a pit in your stomach when it happens, but there have been several times when we have had big down moves in stocks and we make the decision to stick with it because nothing fundamentally has changed with the company. If it is not within the control of the company, then it is usually something that they will be able to work through.

What is the average turnover in your portfolio?

It is quite low. The average portfolio turnover for the last 5 years for Forward’s SmallMid Core Portfolio was 15.6%

What are the risk management techniques that you incorporate into your process at the portfolio level and at the individual security level?

The portfolio is constructed with a defensive bias by focusing on high quality, profitable companies. However, risk is monitored on an ongoing basis through a variety of measures including beta, standard deviation and sector variance. Sector weightings are also constantly monitored to insure that they stay within the stated parameters relative to the Russell 2500 to limit the portfolio’s downside risk and loss.

Our sector neutrality is probably the most important risk management techniques we use at the portfolio level. We are not market timers, so we will maintain a fully invested portfolio. Cash is normally two percent or less, but is running on the high side right now.

At the security level, we look for liquidity as measured by daily trading value. We like to have at least $1 million in daily trading value in our positions. We look at institutional ownership, favoring companies with lower concentrations of big owners. If an institution wants to move out of a position, it can put significant selling pressure on the stock. We prefer to avoid these situations, if possible.

What do you think distinguishes or differentiates your SMID investment approach from that at other firms? What do you bring to the table that others might not?

Our low turnover portfolio featuring profitable, niche dominant companies with both growth and value elements is, we feel, quite unique. We are very sensitive to reps servicing needs and we don’t want to inundate clients with confirms. We want to hold an investment portfolio of companies that we are comfortable holding over a long period and this is something we don’t see a lot of in our competitive set. We like to call our product an “all-weather” portfolio because it is designed to be in the performance ballpark throughout market cycles. We feel the portfolio’s performance record speaks for itself.

What advice would you leave with investors today about investing in small and mid caps?

Patience. Patience absolutely plays out. Last year, our portfolio outperformed with a 38.5% return in 2009, versus the Russell 2500’s 34.4% return and 34% for the US Dow Jones Small-Cap Index. What really drove that was a very patient outlook. At the beginning of the year, it seemed as though the whole world was falling apart, and perhaps it almost did. What we do is strive to find companies that will survive and thrive. Because we are comfortable with the management teams and the companies’ competitive positioning, we’re comfortable owning them through bad times. March 2009 was a bad time, but we stayed invested. So I guess the underlying advice would be to find
quality companies that you are very comfortable with, you like the way the management runs the company, they pay attention to shareholder value, they have an identifiable competitive advantage, and they can fund their growth through internally generated cash flows and hold onto them. Invest, don’t bet. These are all types of criteria that we use to identify companies that we are going to hold in the portfolio and it is that kind of company that we put into this portfolio.

The point I’d like to hammer home is that many companies pass our quantitative screen for profitability and valuation, but few pass our qualitative screen, which is where we add our value. We are confident in and we are eager to take an ownership position in the companies that make it into the Forward SmallMid Core Portfolio. Owning these companies for a long time we believe will bring our clients closer to their long-term investment goals.

If someone wants more info on the Forward SmallMid Core Portfolio, where can they go?